Fearing that another hedge fund collapse like that of Long-Term Capital Management could trigger a global crisis, international regulators unveiled guidelines Thursday for bank lending to such firms.
"We can never make anything impossible," said William J. McDonough, president of the Federal Reserve Bank of New York, at a news conference. "But we want to make it a lot less likely."
Mr. McDonough, who is also chairman of the Basel Committee on Banking Supervision, said the guidelines ask banks to improve credit-risk management, limit lending to heavily indebted hedge funds, gather better data on the borrowers, and devise more accurate measures of potential losses from these collateralized loans.
The international group of bank supervisors may bolster capital requirements on loans to hedge funds, and could restrict this lending if industry practices do not improve, Mr. McDonough said.
Long-Term Capital collapsed in September, at the height of the global financial crisis. The New York Fed orchestrated a $3.5 billion rescue by creditors, which included many of the country's biggest banks and securities firms.
Industry officials generally welcomed the Basel guidelines.
"There are going to be improvements in practice that result from all of this," said Mark C. Brickell, managing director of J.P. Morgan & Co. and a board member of the International Swaps and Derivatives Association. "Everyone in the industry will assimilate the best current practices into their operations."
"This is a common-sense approach," said a risk manager at a big midwestern bank. "This avoids the direct type of supervision that some central banks had been pushing as the best approach."
Rep. Marge Roukema, R-N.J., chairwoman of House Banking's financial services subcommittee, called the report a "positive step" and said her panel will hold a hearing on it March 17.
Nearly a dozen U.S. banks are significant lenders to hedge funds, though as many as 300 banks may have at least some exposure to highly leveraged firms. Globally, about 80 banks and investment houses have the bulk of the business. The Federal Reserve Board will release more detailed guidelines for U.S. banks on Monday.
Basel faults lenders to Long-Term Capital for dismissing the riskiness of their loans because they were collateralized. The report said lenders failed to grasp that a major market disruption, such as Russia's debt default in August, would make it impossible to liquidate the collateral.
Bankers also did not demand enough details on the hedge fund's investment positions, according to the Basel Committee report.
"Banks need to use their clout as credit providers," said Michael L. Brosnan, deputy comptroller for risk evaluation at the Office of the Comptroller of the Currency and a member of the Basel subcommittee that wrote the report.
"They cannot be deterred by competitive pressures from asking the basic questions and getting the fundamental information that is needed for basic credit-risk management."
Jan Brockmeijer, deputy executive director at the central bank of the Netherlands, who headed the Basel review, said many banks already have improved their credit risk management. The guidelines are still needed to prevent banks from becoming lax and lowering standards, he said.
Mr. McDonough said a separate Basel subcommittee is exploring whether to raise capital requirements for loans to hedge funds as part of a general overhaul of the risk-based capital accords. That review is expected to be finished by the end of March, Mr. McDonough said.
The new capital accords would not give banks the option of using models to set capital requirements, he said. Instead, Basel Secretary General Daniele Nouy said the group will refine the current structure, adding more risk categories.
The Basel hedge fund guidelines are available at www.ny.frb.org.
